Can ESG and impact investing help to drive eco-innovations further?

List of Abbreviations

Winnie Chung

Published in

ESG & Sustainability 101

16 min readNov 30, 2021

CBI

Climate Bonds Initiative

ESG

Environmental, social and governance

GIIN

Global Impact Investing Network

GRI

Global Reporting Initiative

IFC

International Finance Corporation

IIRC

International Integrated Reporting Council

IPCC

Intergovernmental Panel on Climate Change

IRR

Internal rate of return

PRI

Principles for Responsible Investment

R&D

Research and development

SDGs

United Nations Sustainable Development Goals

SMEs

Small and medium enterprises

OPIC UN

Overseas Private Investment Corporation United Nations

UNEP FI

United Nations Environment Finance Initiative

WHO

World Health Organisation

Introduction

Environmental problems are becoming more evident and critical around the globe. For example, the IPCC has urged the world to limit global warming to 1.5°C rather than 2°C to reduce the irreversible impact on the ecosystems (IPCC, 2018); 91% of the world population is living in areas where the air quality did not meet the WHO’s standards (WHO, 2019) and by the end of 2050, there might be more plastic than fish when measured by weight in the ocean (The Ellen Macarthur Foundation, 2017).

Companies, who may be blamed as a heavy consumer of natural resources and producer of pollutions, are receiving higher expectation form the public to operate responsibly. There are guidelines and standards such as the PRI initiated by the UN to encourage companies to measure and disclose their ESG information. The public can decide to invest in companies with better ESG performance.

In addition to ESG investment, some investors set up impact investing funds to invest in projects with positive environmental and social impact.

However, some people may argue investing in ESG and impact elements are niche concepts with high risk and low return.

Given this, this essay aims to evaluate the above statement critically. This will start with an overview of ESG, impact investment and its relationship with eco-innovation. After that, concerns related to the investment will be listed out and presented with counter-arguments. Then, there will be brief recommendations related to policy improvement. Finally, to conclude that I disagree with the statement.

The concept of responsible investment could trace back to 1970s when the system of apartheid took place in South Africa. Some corporations from the United States opposed by withdrawing their investment there (Beaty and Harari, 1987).

Background of ESG and impact investment

From the 1990s onwards, some investors excluded tobacco, military, fossil fuels or other industries which were against their companies’ values from their investment portfolio (Schneider, 2014; Apfel, 2015).

In addition to invest or disinvest based on religious or moral values, the concept of ESG investment emerged in the late 1990s. Different indices (e.g. the MSCI ESG Indices; The FTSE4Good Index; Dow Jones Sustainability Index) were released to quantify and rank the ESG of companies, which allowed easier benchmarking and guided investors to make proper investment decisions.

In 2007, the term “impact investment” was coined by The Rockefeller Foundation (Saadia, 2018). Impact investment can be defined as “…investments made with the intention to generate positive, measurable social and environmental impact alongside a financial return.” (GIIN, 2018). This concept is different from philanthropy which mostly focused only on impact (Viviers, Ractliffe and Hand, 2011).

Currently, there is no official definition of eco-innovation. It can be defined as “innovations that aim at reducing the negative environmental impacts caused by production methods (process innovations) and products (product innovations)” (Hemmelskamp, 1997, P.178). Eco-innovation can also be achieved through organisational and marketing change and there are various performance indicators to measure eco-innovation (García-Granero et al., 2018).

With the increasing public expectation on ESG performance, companies may incentivize to invest in R&D, which may lead to eco-innovation. A study in Slovenia found that customers’ demand for green products, environmental policy instruments and increasing environmental awareness from managerial level drive process eco-innovation (Hojnik and Ruzzier, 2016). In developing countries, a study in Nigeria found that regulatory framework and demand for better consumer products impact significantly on firm’s willingness on eco-innovation in the manufacturing sector (Sanni, 2018).

There was an increasing demand to invest in companies with green technologies (Voica et al., 2015). According to the GIIN, 26% of the surveyed population was invested in the energy sector and over half of the studied population had a strong commitment to measure both environmental and social impact of their funded projects (Mudaliar et al., 2018). Therefore, the impact investment, to some extent, can been seen as supporting the eco-innovation development.

To start with, the lack of understanding of ESG reporting in SMEs could be one of the reasons why this concept is considered a niche. SMEs had accounted for around 90% of business worldwide and played a crucial role in global economic growth (IFC, 2012). However, the GRI database revealed that only 10% of ESG reports were from SMEs compared to 90% of the reports from large and multinational corporations (GRI, 2016).

Sustainability disclosure regulations had significant positive effect on the disclosure behavior of firms (Ioannou and Serafeim, 2017). However, not many countries impose requirement or regulations on ESG reporting. For example, only until 2020 China had required all listed companies to publish their environmental information in their business reports (PRI et al., 2018).

In addition, ESG performance in separation with financial performance had often led to a lack of comprehensive evaluation of firms (Roth, 2014). The concept of an integrated report is promoted as a solution for better communication, lower risk and save costs (The International Integrated Reporting Committee, 2011). However, there are little early adopters. Among 500 companies in the S&P 500 index, only 9% adopted integrated reporting (Kwon, 2018).

Besides, companies or rating agencies may provide false ESG information to investors, which can be known as greenwashing (Windolph, 2011). There were challenges related to the reliability of ESG indices such as bias and lack of methodology transparency (Windolph, 2011).

In the impact investment sector, one study showed the “lack of track record of successful investments”, “shortage of quality investment opportunities” and “inadequate impact measurement practice” were considered as top 3 challenges to the growth of impact investment industry (Saltuk et al., 2011).

Another concern related to impact investment is the fund may not necessarily drive eco-innovation. It is because the successfulness of eco-innovation also depends on other factors such as technological and institutional lock-in effect (Foxon, 2002) or the firm’s internal capability (Sanni, 2018).

Even though shortcomings are observed, there are ways to reduce investment risk, increase return and drives for eco-innovation in ESG and impact investment. These will be explained in the next session.

ESG as an investment strategy

Company’s financial performance can be affected by ESG-related risks directly or indirectly (Koehler and Hespenheide, 2013). For example, there are operational risks such as environmental pollution, employee health and safety; supply chain risks such as the supply of natural resources and product risk such as the use of toxic materials (Koehler and Hespenheide, 2013). Therefore, ESG reporting allowed companies to spot out problems and mitigate the possibilities of crisis (Koehler and Hespenheide, 2013).

Many studies had proofed the positive correlation between companies who performed well in ESG and their financial performance. Friedea, Buschb and Bassenb (2015) stressed the importance of long-term and responsible investing and analysed more than 2000 empirical studies since the 1970s. They concluded that around 90% had nonnegative ESG and corporate financial performance relation, a majority of them had positive rather than neutral relationships.

In the perspectives of investors, investing in ESG indices does not necessarily related to low financial return.

By evaluating literature related to ESG investment in emerging markets, Sherwood and Pollard (2018) indicated the investors could receive higher returns and lower downside risk compared with non-ESG investment. Similarly, Jain, Sharma and Srivastava (2019) looked into the investment data between 2013–2017 to examine the financial return between conventional financial indices and ESG indices. They concluded there is no significant difference and suggested the ESG investment can be a good substitute for traditional investment.

For companies who are willing to disclose ESG information, they are more likely to enjoy the benefits of lower cost of raising capital, easier to attract investors and raise more capital (Dhaliwal et al., 2011). For investors, ESG factors can provide them lower volatility, lower investment risk and result in higher risk-adjusted returns to the stock performance (Ashwin Kumar et al., 2016).

Also, ESG investment is a widely accepted concept and applicable in different countries.

The proven track record of ESG investment to provide a balance between risk and return had successfully attracted large scale and long-term investors. The Government Pension Investment Fund in Japan, one of the world’s biggest pension fund, selected ESG indices such as the S&P/JPX Carbon Efficient Index for investment (Government Pension Investment Fund, 2018). Some of the most significant European pension funds such as the Government Pension Fund from Norway and National Civil Pension Fund from the Netherlands also invested in ESG indices (Vitols, 2011).

ESG indices can also be used by top management in companies for benchmarking (Jain, Sharma and Srivastava, 2019). It may motivate companies to innovate and to outperform their competitors. A virtuous cycle can, therefore, be created: better ESG performance may yield a better reputation and in return for higher revenue. More capital can then be allocated for R&D which may contribute to the improvement of ESG performance.

Apple was once considered as an unethical company which drive economic over social and environmental values. A report had revealed the problem of air pollution, workplace chemicals and improper disposal of hazardous waste by Apple suppliers in China (Friends of Nature, The Institute of Public & Environmental Affairs and Green Beagle, 2011). Several eco-innovation projects were carried out in past years such as the invention of state-of-the-art phone dissemination robots and implemented 100% renewable energy for all facilities (Apple Inc., 2018). Though there are rooms to improve in social and governance aspects, its overall ESG ratings have outperformed its competitors since 2016 and the stock price also improved (Sustainalytics Inc. and Yahoo Finance, 2019).

Impact investment as an investment strategy

The impact investing market has been mushrooming since the concept was coined in 2007. By 2018, the market has doubled to USD 228 billion, compared with USD 114 billion in 2017 (Mudaliar, Bass and Dithrich, 2018). A variety of stakeholders had participated in the impact investment market: government, financial institutions to businesses and individuals.

In 2016 and 2017, Apple had raised a USD 2.5 billion worth of green bonds to fund its environmental projects with a guaranteed return (Apple Inc., 2017). It is estimated that the 10-year green bonds can gain 95 to 100 basis points more than the US Treasuries (Bloomberg NEF, 2017).

The government can also play an essential role in impact investment. In 2017, the OPIC led by the United States government had supported 52 deals with a total worth of USD 1.7 billion in supporting high-impact sectors such as renewable energy in developing countries (OPIC, 2017).

The Impact Investing Benchmark had analysed the performance of 51 investment fund. For the funds raised under USD100 million, they generated a 9.5% net IRR to investors which outperformed other conventional funds (4.5%) (Cambridge Associates and GIIN, 2015).

There are several ways to reduce the risk of impact investment.

For example, green bonds with certification from the CBI can provide investors with assurance and credibility in the quality of bonds (CBI, 2019). In addition, investment managers’ skill and due diligence “are critical steps in the investment process and are important factors in obtaining superior returns and in risk management” (Cambridge Associates and GIIN, 2015, P.19).

Different methods are also available for investors to measure the breadth and depth of the impact created and to control investment risk.

Many research had been conducted in academia. Reeder and Colantonio (2013) analysed 15 impact assessment methods such as social return on investment, cost-effectiveness analysis and balanced scorecard; Jackson (2013) stressed the importance of theory of change and considered it as core element in impact evaluation; Florman, Klingler-Vidra and Facada (2016) proposed a “External Rate of Return” platform to improve existing measurement frameworks.

International institutes such as the GIIN introduced Impact Reporting and Investment Standards while the B Analytics, a subsidiary from the B Corporations, introduced a Global Impact Investing Rating System (B Analytics, 2019; GIIN, 2019). Besides, the IFC introduced nine operating principles to guide impact management (IFC, 2018).

In the business sector, TPG, a private equity firm, launched the Rise Fund and built a method called the Impact Multiple of Money to measure their impact from sourcing to exit of the project (The Rise Fund, 2019). TPG estimated their investment of USD 70 million to an Indian renewable energy company can avert more than 16 million tons of carbon dioxide (The Rise Fund, 2018).

For the €1.5 billion green bonds dated 2014–2019 released by KfW, a German state-owned development bank, it was estimated to reduce the costs associated with fossil fuels by €101 million per year (KfW Group, 2018).

Impact investment and eco-innovation are also closely related.

Some innovative solutions created by ventures could only be impactful if they are provided with sufficient capital and resources to accelerate their business to commercially sustainable scale (OPIC, 2017). In other words, without financial support, some life-changing projects maybe overlooked and can hardly reach early adopters, overcome lock-in effect or accelerate technological change. The barrier to reach commercialisation stage can be explained through the concept of “valley of death” (Frank et al., 1996; Markham et al., 2010; Nemet, Zipperer and Kraus, 2018).

With the characteristics of seeking long-term, low risk and stable return, the pension funds had been suggested by the OECD as an enabler for driving a low-carbon economy. The OECD mentioned how the USD 28 trillion of pension funds from its members can make a considerable impact by investing into green financial products such as green bonds to accelerate the deployment of green technologies and close the gap between the reality and the vision of SDGs by 2030 (Della Croce, Kaminker and Stewart, 2011).

In addition to internal R&D, some companies create their impact investment fund to source innovative projects which can benefit their business. For example, since 2015, H&M launched the Global Change Award and invest €1 million each year to commercialise the winning products (The H&M Foundation, 2018).

Outlook: Policy Support for a Better ESG and Impact Investment Environment

The public reluctance of investing in a social cause, a specific sector or a technology may come from the uncertainty about policy roadmap or future trends.

Mazzucato (2017) proposed government to implement mission-oriented innovation policies to solve “problem-specific societal challenges”, which encourage cooperation between various departments and support the diffusion of economically viable radical or incremental innovation in society.

On the other hand, Rennings (2000) suggested how policy mix (from eco-audits to command and control instruments) can push or pull environmental innovation. These regulations can guide investors on environmental-related future changes and make a decision on ESG or impact investment.

Conclusions

Companies are receiving higher expectation from the public to operate sustainably. Some companies may conduct an audit on their ESG performance to attract investors or to fulfil the government’s regulations. In addition, some eco-innovative solutions are supported by impact investment funding. What makes impact investment different from ESG investment is the former can provide additivity gain to environmental and social benefits, which is different from formal compliance such as ESG.

Though some people may consider both investments as niche, with high risk and low return. This essay has argued, supported with academic research and real-life examples, that these investments are increasingly popular and had similar returns compared with conventional investments. Many measurements and evaluation methods are already developed by academics, institutions or companies to provide information transparency for better monitoring and lowering investment risks. As shown in the examples, ESG and impact investment can also support eco-innovations. Therefore, I disagree with the statement.

To allow the ESG and impact investment market to continue to thrive, the government is suggested to adopt mission-oriented thinking or introduce various policy mix to create a safe and supportive investment environment.

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Appendix A

Positive correlation between Apple’s stock price and its ESG performance

Figure 1. Apple’s stock price as at March 2019

Figure 2. Apple’s ESG performance compared with industry average as at March 2019

Source: Sustainalytics Inc. and Yahoo Finance (2019) Apple Inc. (AAPL) Environment, Social and Governance (ESG) Ratings. Available at: https://finance.yahoo.com/quote/AAPL/sustainability/ (Accessed: 25 March 2019).

Appendix B

The Valley of Death illustrated with NPD (new product development) examples

Source: Markham, S. K., Ward, S. J., Aiman‐Smith, L. and Kingon, A. I. (2010) ‘The Valley of Death as Context for Role Theory in Product Innovation’, Journal of Product Innovation Management, 27(3), pp. 402–417.

Appendix C

Determinants of eco-innovations: Technology, market and regulatory elements

Source: Rennings, K. (2000) ‘Redefining innovation — Eco-innovation research and the contribution from ecological economics’, Ecological Economics, 32(2), pp. 319–332.